Heartland Small Cap Value Strategy 1Q18 Portfolio Manager Commentary

Executive Summary

Your portfolio outpaced its benchmark and benefited from strong performance in Energy, Materials and Utilities.

The continued obsession with large tech companies has created a very narrow market, which is not normal, nor healthy.

We sense strong catalysts for change in an investment landscape dominated by growth and momentum.

“The public buys the most at the top and the least at the bottom”

—Bob Farrell

Legendary analyst

First Quarter Market Discussion

Looking at recent fund flow data, the perspective offered by Mr. Farrell above seems like a prudent warning for investors still obsessed with high-flying tech darlings.

According to Thomson Reuters, Tech-focused funds have seen record inflows this year.

As billions flow into big-name Tech, prices skyrocket: Year-to-date, Netflix (NFLX) is up over 54%. It’s not alone. Amazon (AMZN) has soared 24%. This price action has launched valuations into the stratosphere: Netflix is priced at over 100X estimated earnings. Not to be outdone, Amazon trades at 172X.

Once again, a handful of stocks—FAANGs (Facebook, Inc., Apple Inc., Amazon.com, Inc., Netflix, Inc., and Alphabet Inc., parent company of Google)—are driving year-to-date performance. This short-sighted focus on IT momentum has created a very narrow market, which is not normal, nor healthy—we’ve already seen some painful wobbles in late March and wouldn’t be surprised to see more in the months ahead.

Time for a Reboot?

We believe the equity market is at an inflection point and selling pressure late in the quarter is signaling Value is poised to outperform momentum/Growth. Here is our reasoning:

Reversion to the mean. We are in one of the longest stretches of growth beating value in modern history—the gap between haves and have-nots as shown below has reached a level that is difficult to ignore!

End of a Trend?

Russell 2000® Value Less Russell 2000® Growth Index

10-Year Annualized Rolling Returns

Source: FactSet Research Systems Inc., Russell®, and Heartland Advisors, Inc., 3/31/1988 to 3/31/2018, annualized return over rolling 10-year periods. Additional information for indices shown at end of material. All indices are unmanaged. It is not possible to invest directly in an index.Past performance does not guarantee future results.

Higher interest rates traditionally favor Active Value. Not all businesses are impacted the same by higher borrowing costs; it takes active analysis to separate the winners from losers.

Leadership change. The backlash against technology is building. Facebook Inc. (FB), the privacy abuser, is under attack here and abroad—can increased regulation be far behind? If so, will the market treat FB as a Utility instead of a tech high-flyer?

Lower taxes. Recent tax reform is pro-growth and should reduce the burden on small companies and encourage business investment.

Law of large numbers—AMZN has a mkt cap of $700 billion—it will take more than chump change to move the performance needle on the Big Tech names highlighted below.

Sizeable Change

Top 10 Holdings in S&P 500 Index (Billions)

Source: FactSet Research Systems Inc., Standard & Poor's, and Heartland Advisors, Inc., as of 3/29/2018
Market values displayed in red indicate holding is from IT sector.

So who will take the baton once Big Tech loses its way? While we don’t make industry or sector calls, we do believe that tomorrow’s leaders will have common characteristics:

They’ll serve unique niches

Strong balance sheets

Capable, committed management

Compelling valuations

Identifying these traits continues to be the foundation for our work at Heartland, and focusing on them is one of the surest ways we know of avoiding the flawed approach Mr. Farrell describes. The following highlights just a few of the compelling investments held in your portfolio that we’ve found away from the limelight.

Little Tech That Could

Fabrinet (FN), a contract manufacturer specializing in optical communications equipment, was up sharply after reporting better than expected earnings for the quarter. We were encouraged by the results and believe the company is poised to capitalize on long-term demand for optical components. A jump in the creation of data centers, domestic telecom upgrades and surge in broadband demand in China, all point to significant growth in the optical space. Additionally, the company has driven robust growth in its automobile and medical business lines.

Fabrinet serves many of the household names in tech, has a strong prospects for growth, little debt, yet sells at the lowly level of just 10X estimated 2018 earnings—half the multiple of the popular indices.

Net of $6 per share in cash the business is priced at 7.4X estimated 2019 earnings, remarkably low in our view for a company which has more than doubled sales the last 5-years to an estimated $1.35 billion.

Seeing the Cloud Through the Fog

Information Technology holdings like Fabrinet helped boost returns and the sector was also the source of compelling opportunities like Mitel Networks Corporation (MITL).

Mitel sells communications equipment for commercial applications. The company’s long history in premise-based systems, similar to landlines for household use, has created a misperception, and opportunity for active investors. While the market is focused on the company’s legacy business, Mitel has developed a robust cloud offering and now is the second largest player in cloud-based telephone systems.

With its significant legacy business, Mitel has an established client base ripe for conversion to its new systems. The upshot is the business is well positioned to generate incremental revenue from the two-thirds, roughly 47 million, legacy seats that no longer pay any fees for existing equipment. As the company gains traction in the cloud-based channel, last quarter bookings were up 26%, we believe MITL will be accorded a higher multiple closer to the pure-play peers. Despite its strong growth forecast, shares sell for just 11.1X this year’s estimated earnings, a fraction of what the FAANGs are commanding.

The Utility of a Different Perspective

With roughly half of the Strategy’s assets in names not included in the benchmark, it is hard to imagine anyone can question our willingness to go against the tide when pursuing value. But for those who doubt our contrarian chops, we offer a one-word response: Utilities.

Once the darlings of those chasing yield and trying to position themselves for an economic downturn, the group has fallen out of favor during the past year. Yet it is the dramatic turn in sentiment that has piqued our interest and led to the discovery of what we believe are hidden gems.

Everything’s Bigger in Texas

InfraREIT, Inc. (HIFR), a real estate investment trust that owns regulated utility assets in Texas, is a vivid example. The business operates in the state with the strongest electric demand growth in the country and leases its assets to a traditional power provider. Furthermore, HIFR is active in two of the fastest growth markets in the state—West Texas, where activity is high in the Permian basin, and the Panhandle, where there is significant wind turbine activity.

Despite operating in one of the most attractive utility markets in the country, the company trades at an extremely attractive valuation profile, in our view, selling at only 1.3X tangible book value with a hefty 5.0% yield.

Unloved and Undervalued

With short-term interest rates on the rise, investors also soured on yield sensitive areas such as Real Estate. The portfolio’s holdings in the space outperformed those in the benchmark and we continue to find excellent companies that have fallen victim to negative sentiment.

Care Trust REIT, Inc. (CTRE) continued its impressive showing since its spin-off from a leading health care services company in 2014. This real estate investment trust specializes in managing and acquiring and leasing skilled nursing, assisted living and independent senior housing. CTRE’s focus on regional, mid-market locations along with its seasoned management team makes it a differentiated player in the industry.

With 191 properties and nearly $1.2 billion in assets, we estimate the company’s pro forma debt/capitalization stands at a conservative 23% and its interest coverage ratio at a robust 4.9X. This balance sheet strength should provide it with dry powder to use to opportunistically acquire additional properties. Care Trust’s accomplished management team has been able to generate an impressive 9% yield on its properties in 2017. In mid-March, management boosted its quarterly dividend by 11%. With a payout ratio estimated at only 63% of funds from operations, the company has ample opportunity to grow its 5.8% dividend yield. We believe factors such as aging population, industry supply constraints, and increased cost of treatment alternatives will benefit this well-run REIT.

Despite its financial strength and attractive yield, Care Trust trades at just 10.7X funds from operations compared to 12.6X for its peers.

The Case for Staying the Course

There has been enormous pressure on investors to throw in the towel on value stocks, and small companies in particular. To those who ask “Why stay the course?” we would point to Mr. Farrell’s observation.

This run for equities has been largely driven by a sliver of large tech names. Recent mega inflows into the space, in our view, only strengthen our conviction that the best days for Big Tech may be drawing to a close. As such, we remain steadfast in our commitment to forgo those overpriced, over-owned, and over-loved areas of the market.

While the masses have been clamoring to get in at what looks to us like top dollar, we’ve focused on the path less traveled where interest appears to have bottomed. What we’ve found are compelling investments that should shine long after the glow of popularity has faded for today’s trendy investments.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 50 years of industry experience, 36 at Heartland.

*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988.
**Shown as supplemental information.

The U.S. dollar is the currency used to express performance.

Past performance does not guarantee future results.

The Small Cap Value Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Economic predictions are based on estimates and are subject to change.

There is no guarantee that a particular investment strategy will be successful.

Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”). Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose. The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

Additional Information for Indices in Chart (calendar year returns %):

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

YTD 2018*

Russell 2000® Growth Index

1.23

43.09

-22.43

-9.23

-30.26

48.54

14.31

4.15

13.35

7.05

-38.54

34.47

29.09

-2.91

14.59

43.29

5.62

-1.38

11.32

22.17

2.30

Russell 2000® Value Index

-6.45

-1.49

22.83

14.02

-11.43

46.03

22.25

4.71

23.48

-9.78

-28.92

20.58

24.50

-5.50

18.05

34.50

4.22

-7.47

31.74

7.84

-2.64

*As of 3/31/2018Source: FactSet Research Systems Inc. and Russell®Past performance does not guarantee future results.